Series on Trust: When Entrepreneurs and VCs Break Up

We met with some of our large investors recently, and one of them mentioned: “VC is a trust business.”  He was saying that he trusted us.

I’ve been thinking a great deal about what he said.  I think trust in venture capital is critical, and it is something that covers multiple dimensions.  So, I’d like to write a blog series about trust.

For starters, we think that VC is a business just like any other.  As such, it has stakeholders:

  • The entrepreneur: we think they are a VC’s customers
  • The investors in the fund: they are called “Limited Partners”
  • Partners in the VC firm: these are the folks in the legal docs and are named as part of the “General Partner.”
  • Non-partners in the VC firm: they may include Venture Partners, Partners, Principals, Associates, finance executives, office managers and executive assistants.  Some of these folks have investing roles, and are hugely valuable, but they’re not partners if they’re not in the legal documents

We think that stakeholders are like legs in a chair.  When one is wobbly, the entire structure is de-stabilized.  One major wobble factor: dis-trust.

In this post, I’ll cover the importance of trust between an entrepreneur and a VC.

First, let’s look at trust from a VC’s standpoint.  When he invests in a start-up, he needs to have a lot of trust in the entrepreneur.  That’s because the VC is there for board meetings and assistance, but is essentially an outsider.  An entrepreneur can lie to the VC.  Lies will eventually be discovered, but it will take a long time.

For example, one founder I know started a company, received a lot of venture backing, and later, secretly started a new business and shopped around for a financing.  I know this because I am the first VC he approached.

You see, I had invested in his earlier company, and left that board when I started Kepha (which is the customary protocol in VC).  He later approached me a few times in secret about his new idea.  I told him I was uncomfortable.  I did not want to betray the management team, whom I had worked hard to recruit to that venture.

So, I told him I would start diligence only after he came clean with his current board and colleagues that he wanted to leave.  He wasn’t willing to do so.  He then approached me a few more times, and I continued to stick to my guns.  I told him I didn’t understand why he wouldn’t tell the truth.

In the end, he approached other firms, received funding, and then quit from his original start-up.  His previous management team was completely shocked, disappointed and hurt.  No executive from his old team joined him at his “new” venture.  He lost their trust.

Now, let’s look at trust from an entrepreneur’s standpoint.  Trust here is critical.  The VC can fire the entrepreneur, but the entrepreneur cannot fire the VC.  It is an assymetrical power relationship.  Yes, the VC’s reputation is at stake if he behaves badly.  But, the reality is that he can fire the entrepreneur, or decide not to invest in the next round, which is a negative signal to any prospective new investor.

So, it’s very important that start-ups can truly trust the VC.  Here’s a very real example.   One CEO, hired by a founder, was raising money for a start-up.  My partner Eric really liked the idea but told him that he did not think he was the leader for the start-up.  The CEO was insulted and shopped the financing elsewhere.

Three VCs at well-known firms decided to invest.  They too thought the CEO was not back-able.  But, they decided together not to tell him that, as they didn’t want to lose out on the investment.  So, they invested.  One month later, they fired the CEO and appointed the founder to lead the company.  Unfortunately, the CEO had moved his entire family to be closer to the start-up.

Now, I think 99% of the VCs I know will be very honest about their thinking.  So, this isn’t an indictment of VC “bad behavior”.  Bad behavior exists everywhere, in all circles.

But, I want to emphasize that it’s very important for the entrepreneur to get to know a VC.  Take your time and get to know someone.  Do a lot of reference checking.  Understand who the VC is and why he is working as a VC.  Don’t be overly enamored with a firm’s brand.  Then, trust your gut.  I always tell my entrepreneurs: it isn’t about a firm’s brand, it’s about that individual VC.

So, it’s about trust.

In next week’s post, I’ll write about why institutional investors need to trust their VC.

 

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